CHAPTER FIVE

PLANNING AND PERFORMANCE EVALUATION IN MULTINATIONAL

ENTERPRISES

INTRODUCTION

♦ This lecture special problems faced by management in controlling the

multinational enterprise.
♦ As with control in a domestic environment, control in the global environment
begins with a strategic objective and includes all elements of planning and
monitoring the success of a global strategy to meet those objectives.
♦ The focus of the planning process is to give strategic direction to the firm and
then an operational plan to get the firm to achieve the strategic direction.
♦ The role of the management accountant in this planning process is to work with
top management to identify the necessary performance criteria and then to
monitor achievements against these criteria.

THE STRATEGIC CONTROL PROCESS

♦ In a study of European MNEs by Professors Gupta and Govindarajan (1991), the
following stages in a formal strategic control system were identified:
• Periodic strategy reviews for each business, typically on an annual or less
frequent basis.
• Annual operating plans, which increasingly include non-financial measures
along with the traditional financial ones.
• Formal monitoring of strategic results, which may be combined with the
budget monitoring process, and
• Personal rewards and central intervention.
♦ Benefits from a formal process:
• Greater clarity and realism in planning.
• More “stretching” of performance standards.
• More motivation for business unit managers.
• More timely intervention by central management, and
• Clearer responsibilities.

♦ For such a system to work, it is necessary to:

• Select the right strategic objectives based on an analysis of the competition
and the strengths of the firm.
• Set suitable targets according to the strategy of the firm for example:
 ROI for a fully-fledged strategic business unit (i.e., a unit of a group of
companies which makes its own business decisions at all levels, e.g., a
major division or subsidiary).
 Standards benchmarked on the performance based of key competitors,
♠ Unfortunately it is often difficult to get good data on global
competitors.

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 • Design a system tight enough and demanding enough to put pressure on
management to perform
• Ensure that the process does not get so big, complicated, and bureaucratized
that it gets in the way of creative thinking and solid performance.

♦ Control Problems unique to a global company/environment include:

• Different operating environments make it difficult and complicated to
establish and implement a strategic control system.
• Problems include culture; legal systems; political differences that could
influence the role the firm is allowed to play in the country; and economic
systems
• An example of strategic objectives is shown in Figure 5.1.

CHALLENGES OF CONTROL IN THE GLOBAL FIRM

Planning and Budgeting Issues

♦ The major international issue surrounding the establishment of a budget for an
MNE is to determine the currency in which the budget should be prepared: the
local currency or the parent currency.
♦ The foreign currency issue also raises the issue of controllability vs.
understandability because as currencies rise or fall in value beyond the control
of a single MNE the following issues occur:
• Performance evaluations of managers should exclude the impact on results
of events over which the unit or person had no control.
 Normally managers have no responsibility to hedge against potential
foreign exchange and their performance should be measured on an
before-translation basis is better than the after-translation basis
 If a manager is given the authority and responsibility to hedge against
potential foreign exchange losses, then he or she could be evaluated in
terms of translated profitability.
♦ On the other hand, it is often difficult for top management in the parent country
to understand budgets generated in different currencies.
• Translating the budgets into the parent currency allows top management to
consolidate the budgets into a firm wide view of the coming year.
• Also, top management has to report to shareholders in the parent currency,
might want the strategic business unit (SBU) or subsidiary management to
think in terms of parent country profitability as well.

Ways to Bring Foreign Exchange into the Budgeting Process

♦ Table 5.1 identifies the different ways that firms can translate the budget from
the local currency into the parent currency and then monitor actual
performance.
♦ It proposes using three different exchange rates:
 Actual exchange rate in effect when the budget was established, - called
the Actual at budget rate
 Projected at the time the budget was established in the local currency-
called the Projected rate

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  Actual exchange rate in effect when the budgeted period actually takes
place using continuous updating through an average or closing rate.-
called the Actual Rate
♦ The following are the Pros and Cons of using each of the rates proposed above:
 Actual at budget is an objective spot rate that actually exists on a given
day.
 The use of Actual at budget is reasonable in a stable environment (but
not in an unstable environment)
 The use of a Projected rate is an attempt on the part of management to
forecast what it thinks the exchange rate will be for the budgeted time
period.
 Using the Actual rate at FYE/average rate involves frequentlyupdating
the exchange rate that was in effect when the budget was established.
♦ Table 5.2 in the book provides a complex example of a flexible budget that
involves foreign exchange using each of these approaches and comparing
budget and actual.

Budget and Currency Practices

It is interesting to observe what MNEs actually do?
♦ Robbins and Stobaugh (1973), in a study of US Multinationals found that:
• Fewer than half the firms surveyed judged subsidiary performance in terms
of translated dollar amounts,
• Only 12 percent used both Local Currency and Dollar standards.
• Many Companies use Local currency budget and actual figures.
♦ Morsicato (1978) found that a significant number of firms in her sample used
both dollar and local currency budgets compared to actual profits and actual
sales.

Capital Budgeting
♦ Capital budgeting is the longer-term relation of the operational budgeting
discussed above.
♦ Capital budgeting for global companies must take into consideration a variety of
complex factors including:
 Project cash flows vs. parent cash flows including
 Country impact on remittances to parent such as the risk of unexpected
heavier taxation
 A variety and complexity of cash flows
 Inflation rates
 Unanticipated exchange rate changes
 Political risk such as the risk of expropriation.
♦ Sometimes, when environmental factors are used in long-term strategic
decisions, the outcome may appear to be at odds with the quest for strong ROIs
on a year-to-year basis.
♦ Therefore, capital budgeting may require even more judgement than operational
budgeting.

INTRA-CORPORATE TRANSFER PRICING

♦ This refers to the pricing of goods and services that are transferred (bought and
sold) between members of a corporate family – for example, parent to
subsidiaries, between subsidiaries, from subsidiaries to parent, and so on.

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♦ Different Corporate Units may transfer
• raw materials,
• semi-finished and finished goods,
♦ Head Office Units may allocate
• fixed costs,
• loans interest
• fees,
• royalties for use of trademarks, copyrights,
♦ In theory, such prices should be based on production costs, but in reality they
often are not.
♦ One of the important reasons for arbitrarily establishing transfer prices is
taxation.
• If it were not for differences in tax rates worldwide, companies could allocate
corporate overhead based on sales revenues in each subsidiary or on some
other economic basis
• Different tax rates complicate the situation.
 For companies headquartered in high tax countries, there is an incentive
to charge as many expenses as possible against parent company income.
 Some tax authorities notably the US IRS provide specific guidelines on
how to allocate expenses between domestic and foreign source income.
 The problem with using tax law to allocate overhead is that it likely
eliminates any possibility for the firm to select an allocation basis that is
consistent with its manufacturing strategy. As Hiromoto (1988) shows,
Japanese managers are less concerned about how allocation techniques
measure costs than they are about how the allocation techniques
motivate employees to drive down costs.
♦ Taxation is only one of a number of reasons why internal transfers may be
priced with little consideration for market prices or production costs.
• Other factors include for non market transfer prices include:
 Competition /Market -Share companies may deliberately under-price
goods sold to foreign affiliates so the affiliates can then sell them at prices
that their local competitors cannot match.
 Circumventing national controls -High transfer prices might be used to
circumvent or significantly lessen the impact of national controls such a:
♠ A government ban on dividend remittances that restricts the ability of
a firm to maneuver income out of a country.
♠ Existing price controls in the subsidiary’s country are based on product
costs (including high transfer prices for purchases).
 Boosting apparent subsidiary profit s-High transfer prices on goods
shipped to subsidiaries might be desirable when a parent wishes to lower
the apparent profitability of its subsidiary.
♦ Table 5.3 summarizes the particular conditions that firms use to determine a
particular level of transfer price.
• Unfortunately for firms, conditions seldom line up as nicely from their
standpoint as either column of Table 5.3 depicts.
• It is far more likely that a country will simultaneously experience conditions
from both sides of the table.
• It is often difficult to determine whether the firm will receive a net benefit
from high or low transfer prices.

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  For example, a country experiencing balance-of-payments difficulties
typically would be restricting dividend outflows and the amount or value
of imports.
♠ A company using high transfer prices on sales to its subsidiary in such
a country would gain with respect to taking out more money than it
might otherwise have been able to get out
♠ Said company would lose by having to decrease the quantity of
imported materials its affiliate needs to compete.
Target Costing
♦ A market-driven system
♦ Target costing more broadly refers to the process of reducing the time for
developing products, defining quality for a new product, and containing cost
generally.
♦ Developed by the Japanese,
♦ Differs from engineering-driven costing in that it determines the product cost by
establishing a competitive market price and then subtracting a profit margin
that is consistent with the company’s long-range strategy.

PERFORMANCE EVALUATION ISSUES IN MNE’s

♦ Performance measurement is never easy…making matters even more
complicated are the interdependencies of an MNE’s operations.
• One reason for this is that different bases of measurement result in different
measures of performance.
• Moreover, the individual or unit being evaluated does not control many
events affecting performance.
• Strategic differences in subsidiaries may also result in different performance
evaluation measures.
 For example, a multinational automobile company may produce its steel
in Japan, have it stamped in the United States, have its tires made in
Canada, its axles in Mexico, its engines in Germany, and its radios in
Taiwan, all for final assembly in the United States.
 If any one part of its far-flung operations experiences performance
problems, that operation’s problems will spread to the other operations.
 Furthermore, transfer prices and target costing can affect prices. If other
than arm’s-length transfer prices were used on any of the inter-corporate
sales, the reported results would not be within the control of either the
selling or buying subsidiary (unless they both agreed to the transfer
price), and in any case, would not reflect real performance.
♦ In the end however if budget plans are to have meaning and credibility they
must be implemented the performance of those carrying out the plan thus needs
to be measured and rewarded.

♦ Gupta and Govindarajan (1991) identify several issues surrounding performance

evaluation that are complex in the global environment. They hypothesize that
subsidiaries can be:
 global innovators,
 integrated players,
 implementers, or
 local innovators.

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 • The impact on the strategic classification is as follows:
 Global innovators and integrated players tend to be high transferors of
knowledge to other units.
♠ Gupta and Govindarajan propose that units that are global innovators
and integrated players need performance evaluation systems that are
relatively flexible compared with the other two groups.
♠ Such systems for global innovators tend to rely more on behavioral
controls, that is, those involving surveillance of the manager’s
decisions and actions, and less on output controls, that is, end results
of performance, than do the other two groups.

Separating Managerial and Subsidiary Performance

♦ It is often difficult but important to separate managerial performance from
subsidiary performance.
• It is possible to have good management performance despite poor
subsidiary performance, and vice versa, again largely as a result of non-
controllables.
• Gupta and Govindarajan point out that some subsidiary managers are better
able to cope with the uncertainty inherent in the foreign environment than
are others.
 In particular, they propose that managers in charge of companies that
are global innovators and integrated players are better able to deal with
ambiguity than are managers of companies that are implementers and
local innovators.
♦ Properly Relating Evaluation to Performance
• MNE’s from western countries especially rely on ROI as the major or one of
the most important measures of performance. This has some major
problems:
♠ Where inter-corporate transfers are significant and are not at arm’s-
length prices, the ROI income numerator is highly arbitrary and, in one
sense, fictitious.
♠ ROI is not appropriate for some foreign operations, such as:
♦ subsidiaries producing only for other subsidiaries,
♦ sales subsidiaries buying all their products from other subsidiaries,
♦ subsidiaries striving to break into highly competitive, low margin
markets.

Emerging Trends in Performance Evaluation

Some emerging trends in performance evaluation include:
♦ Focusing on more specific strategies, such as quality, global efficiency,
productivity improvement, and the building of critical mass.
♦ Focusing evaluation on strategic business units (SBUs) rather than subsidiaries.
• Using the SBU as the key profit center for the firm allows it to concentrate on
global competitors in that same line of business.
♦ Experimenting with a re-engineered approaches to budgeting
 The instructor may wish to have the students read International Bulletin
5.1.
♦ Using non-financial criteria to evaluate performance.
• Some of the important measures that are being used are
 market share,

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  volume,
 productivity,
 quality.

♦ Using economic value added (EVA)® to measure performance

ECONOMIC VALUE ADDED (EVA)®

♦ A relatively recent tool that companies are using to measure performance is
EVA,
♦ What is EVA and how does it work?
• EVA is something economists call economic profit.
• EVA is also used primarily for performance evaluation and compensation
rather than for capital budgeting purposes.
• Basically, EVA is after-tax operating profit minus the total annual cost of
capital.
• EVA is a measure of the value added or depleted from shareholder value in
one period.
• A positive EVA requires that a company earn a return on its assets that
exceeds the cost of debt and equity, thus adding to shareholder value.
• EVA is an actual monetary amount of value added, and it measures changes
in value for a period.

♦ EVA is calculated as follows:

ROIC Return on invested capital: same as operating profit minus cash taxes paid
divided by average invested capital
CofC Weighted average cost of capital: (net cost of debt x % debt used)
+ (net cost of equity x % equity used)
AIC Average invested capital: Average stockholders equity + average debt

EVA = [ROIC – CofC] x AIC